FM W6

Question 1

What are the functions of Foreign Exchange Market

Answer 1

1. Transfer purchasing power from one nation and one currency to another.
2. Provide credit for foreign transactions.
3. Provide the facilities fro hedging and speculation.

Question 2

What is a fixed exchange rate, give and example and discuss pros and cons

Answer 2

Rates are held constant or allowed to fluctuate within very small bands. Eg: Bretton Woods era.
Future exchange rates are known.
Each country is vulnerable to the other economic conditions in other countries.

Question 3

what is a freely floating exchange rate and discuss pros and cons

Answer 3

Rates are determined by market forces without governmental intervention.
Each country is more insulated from economic problems of other countries.
Devote resources to manage exposure of exchange rate fluctuation.

Question 4

what is a managed floating exchange rate

Answer 4

Exchange rates can move freely daily but governments intervene to prevent rates from moving to much in one direction.

Question 5

what is a pegged exchange rate

Answer 5

A currency’s value is pegged to a foreign currency or a unit of account.

Question 6

what are currency boards

Answer 6

A system for pegging the value of a local currency to some other specified currency.

Question 7

what is dollarization

Answer 7

Replacement of a country’s currency with US dollars

Question 8

What do foreign exchange quotations do and what are the two types

Answer 8

Reflect the ask prices for large transactions.
Direct: the value of a foreign currency in terms of the home currency.
Indirect: the number of units of a foreign currency per unit of home currency.

Question 9

what is the effective exchange rate

Answer 9

Weighted average of the exchange rates between the domestic currency and the nation’s most important trading partner.

Question 10

what is arbitrage

Answer 10

The purchase of a currency in one market for immediate re-sell in another market.

Question 11

what is the spot rate

Answer 11

Exchange rate that calls for the payment and receipt of the foreign exchange within 2 business days from the transaction date.

Question 12

what is the forward rate

Answer 12

Exchange rate that calls for delivery of foreign exchange 1, 3, 6, 12, 24 months after the date the contract is signed.

Question 13

what is the forward discount and forward premium

Answer 13

Forward discount = % per year the forward rate is below the spot rate.
Forward premium: % per year the forward rate is above the spot rate.

Question 14

what is a currency swap

Answer 14

A spot sale of a currency and a forward purchase of the same currency - as part of a single transaction.

Question 15

what is hedging

Answer 15

the avoidance of foreign exchange risk.

Question 16

what are the 3 hedging options

Answer 16

1. Buy at current spot rate and deposit receipts in an interest earning account until the funds are needed.
2. Buy a forward contract.
3. Buy a call option.

Question 17

what is speculation

Answer 17

the acceptance of foreign exchange risk with the hope of making a profit

Question 18

what is the difference between stabilising and destabilising speculation

Answer 18

stabilising: purchase of foreign currency when domestic prices decrease, with the expectation it will soon rise.
destabilising: sale of foreign currency when domestic price decrease, with expectation it will fall even lower.